Time is Money – Playing the Odds

Time is Money – Playing the Odds

How does one get rich playing options? It’s easy, just buy the right option at the right time. If the stock that you are picking happens to move in the direction that you pick within the lifetime of the option, you can win many times your investment. Some options that cost as little as $ 12 have risen in price to $ 100 or more within a matter of days. How likely is it though to pick the right stock – the right option at the right time?

What are the Odds?

When comparing a future stock price against today’s, one of three things will happen: the price will rise, the price will remain the same, the price will go down. When you buy an option, you generally are betting that the stock price will either go up or down. This puts you at a severe disadvantage. If the price does not move in the direction that you picked, you would lose all of your money. As you can see, by purchasing an option, you give yourself a one in three chance of winning. Should the price stay the same, you lose. Should the price go against you, you lose.

Let’s say that you are right and the stock moves in the direction you choose. To make your option purchase profitable, the stock price must not only move above the strike price of the option, it must move by an amount that exceeds what you paid for the option. For example, if the stock is at $ 45 and you bought a three month $ 50 call for $ 3, for you to achieve a profit, the stock must move past $ 53 (strike price = $ 50 and $ 3 paid for premium = $ 53). If the stock fails to close above $ 50 when the option life ends in three months, you lose all of your $ 3 investment. I don’t mean to say that it’s not possible to profit from buying options, I just feel that the percentages are against you.

Strike Price Matters

Strike prices or the price where the option will be exercised is an important factor to take into consideration. In the case of our $ 45 stock, where a $ 50 three month option might cost $ 3, a $ 60 call option might only cost $ 1 or less. The price of these out of the money options are determined by the volatility of the stock and the amount of time remaining in the option’s life. Yet even though the probability of a $ 60 option ever becoming profitable is small, they are traded for many reasons. Even $ 70 call options, that might trade at only $ 0.25 are traded. Those that buy such far out of the money options know that there is some probability that these options might turn into winners and are willing to make that bet and pay a premium for it.

Determining Probability

Just as with cards and other games of chance, the better you understand the probabilities, the easier it will be to make consistent money. How can we determine probabilities in the stock market? It’s easy if you have any spreadsheet skills. Free historical price data is readily available on public websites such as Yahoo. You can download data to a spreadsheet and build in your formulas. By developing moving averages and standard deviation figures, you can easily determine the trend of the stock as well as the volatility. By taking the distance that the stock price is away from the price’s moving average and dividing it by the standard deviation data, you can determine where the price is in terms of the Normal Distribution.

The Normal Distribution or Bell Curve is a standard statistical measurement system used in scientific studies. While many will argue that the stock market is not normal, looking at price in this manner is an important tool that you can use. The popular Bollinger Bands study uses a 20 period moving average. The bands are two standard deviations away from the average. What is the significance of two standard deviations? Statistically, 95% of observations will occur within +2 and -2 standard deviations. That leaves just 5% or a 2 1/2% probability that a price will be beyond either the +2 or -2 level.

What does this really mean? We all know that the markets are often ruled by emotion and not rationality. Rising prices cause prices to rise even more as buyers begin to feel that they can’t lose. They keep buying even though prices move into the irrational levels beyond +2. We feel excited when this happens. We are moved by the emotion and a statistical reading of the price would prove it.

The same goes for declining prices. Lower prices cause more selling as fear moves in. The lower prices go, the more scared participants get. I’ve been there. There have been times early in my trading career when I called my broker and told him to sell everything. Don’t even bother calling me back. I don’t want to know. This is Negative Two panic. It’s irrational behavior and the statistical reading will prove it. It is at these levels that we should be taking the opposite action and buying not selling at irrationally low levels and selling, not buying at irrationally high levels. Even with a good spreadsheet tool to show you where you are at in the emotion scale, it still takes discipline the pull the trigger. Negative two levels are accompanied by the worst news possible. Why would anyone want to buy? At Plus Two levels, the news is great. All is well and the outlook forever is nothing but blue skies and big profits. It’s so hard not to “let your profits run.”

Keep a Running Tally

Overbought or oversold conditions can last over a period of time and taking action at the first sign of irrationality may result in your doing the wrong thing at the start of a trend. I have found a useful way to determine when trends begin and end. I call it Size. It is simply the Standard Deviation data that we calculate on our price data. While the number of standard deviation units my not increase much beyond plus or minus two, the Size of the standard deviation unit will increase when price is trending. When Size reverses, there is a good possibility that the trend is coming to an end. Keep in mind these are just tools and as such, you should take the time to study how your favorite stock or index acts over time. Notice how it might vacillate between Plus Two and Minus Two. You might be able to even identify cycles. Notice how when a stock is trending, when Size reverses, the stock might go sideways to the trendline and then again continue the trend.

Now that we have an idea of options and how to take statistical measurements of the stock or index that we watch, we are ready to begin employing some strategies that will result in profits for us. We will discuss these strategies in Part 3.

Gary Lewis’ ideas incorporate more than 30 years working with investments including 20 years experience in the derivatives industry and 10 years as a fee-only comprehensive financial planner. He specializes in designing portfolios that meet the client’s required rate of return with a minimum level of volatility. You can read his writings on financial markets at Asset Design Center.